Profitability seems like such an easy business concept to evaluate. If your revenues exceed your spending, you are profitable. Simple.
And while this simple formula may be very accurate, it provides no insight into the vast array of scenarios that drive profitability within an organization. Making the situation even more complex is the fact that profitability issues can be just as profound when a company is growing as well as when the organization is in decline.
For simplicity, our analysis will categorize symptomatic profitability into three flavors.
What are the 3 types of profitability issues?
- Severe.
- Moderate.
- High-Class.
Severe Profitability Issues
Nobody ever says they are having severe profitability issues. What you typically hear is: “We are losing money.” The additional characteristic that makes the situation severe is when compounding dependencies create a downward performance spiral.
For example, a company with declining sales will suffer from decreasing revenues, which will lead to a weaker cash position. As the strength of cash flows degrade, the ability to cover fixed expenses becomes more difficult, negatively affecting profitability. Cost-cutting measures further restrict an organization’s ability to service existing clients and respond to the root causes of underlying problems. Ultimately, each well-intentioned subsequent decision is often the least bad option. It is very easy to let a series of small adjustments increase the challenge associated with decreasing profits.
Regardless of the situation, addressing severe profitability as a math problem is typically an accelerant to failure. It takes great courage and unconventional thinking to escape a downward profitability spiral.
The courage associated with solving severe profitability issues is to avoid looking at profitability as the problem that needs to be solved. The key is to look at profitability as a symptom of a deeper problem. Only when the core problem is understood can the correct and seemingly unconventional solution make sense.
What are the core problems behind severe profitability issues?
- An inability to hire or retain workers.
- Aging receivables.
- A lack of focus.
- Slow responses to market contractions.
- Inefficient processes.
- An incorrect business model.
- Sales.
Naturally, problems may be due to many of these issues at the same time or even issues that were not mentioned. The key point, however, is that profitability is not the issue. Profitability is the symptomatic outcome of deeper issues.
Moderate Profitability Issues
Like any Pareto distribution, most profitability issues are considered moderate because they tend to be isolated and temporary if addressed promptly. Moderate issues typically surface with comments like: “We’re working harder than ever, but we just don’t seem to have much money left at the end of the month.” The common theme associated with moderate profitability issues is a lack of discipline.
A classic example would be a lack of discipline in expense management. It’s easy to feel good when you are making money and sometimes spending can get out of hand. Of course, everyone in the office needs a new chair. Of course, we can hold our executive meetings in Hawaii this year. Of course, we can finally do that thing we’ve been putting off. Expense controls are a matter of discipline.
This is not to say all moderate profitability issues are because of a lack of discipline. Some moderate issues are short-term bumps in the road. A good example of this is when fuel prices spike because a refinery is shut down after a hurricane. Unexpected events will always happen and can have short-term impacts on profitability. Even then, the companies that deliver profits on a more consistent basis are the same ones that exhibit the discipline to prepare for unexpected events.
High-Class Profitability Issues
If you are going to have an extreme profitability problem, high-class problems are the ones you would prefer to have. If your company’s profitability is declining because you are growing too fast ... you have high-class problems. If your profitability issues are tied to capital constraints because your customers have placed too many orders... you have high-class problems. It’s good to have high-class problems.
There are two important commonalities with high-class profitability issues. First, they occur when everything is going great and business is booming. The second commonality is that the root cause is typically structural in nature. What this means is that 
declines in profitability begin to surface after internal processes are put under strain.
Perhaps the most common problem with high-class profitability is when cash is constrained. A flood of new orders can create the need for additional investments in capital equipment, raw materials and talent in order to satisfy demand. All these expenditures will eventually produce more profit, but in the short-term, profitability suffers. Overtime may temporarily satisfy demand, but the premium can affect profits and quality if long-term scalability is not addressed. Additional capital to support these investments must be acquired in the form of loans or other investment vehicles that eat into normal profit margins.
A twist on this classic example is when broad increases in market demand create shortages of supply-side resources affecting the costs of production. Whether the shortage is for 304 stainless steel or Python programmers, the price to obtain raw materials or hire talent goes up. Further exacerbating the profitability challenge is the fact that additional fees such as expedited freight or signing bonuses degrade the best efforts to support existing profit levels. And while some price increases can be passed on to customers, that process frequently lags the investments necessary to keep pace with market demands.
As is the case, profitability problems increase exponentially at the extremes. It is not uncommon to see your business boom at the same time everyone else’s business is booming. And then, all these scenarios can feed on one another as the strain of success envelops an organization. Running a business is a tireless affair. But the freedom of being your own boss and doing things your own way comes at a price. And the price of entrepreneurship includes business requirements that shackle you to boring functions like accounting, insurance and taxes.
Excerpted from the book Clarity: Business Wisdom to Work Less and Achieve More by Jim Vaselopulos. Copyright © 2023, Rafti Advisors, LLC. All rights reserved. No part of this book may be used or reproduced by any means, graphic, electronic, or mechanical (including any information storage retrieval system) without the express written permission from the author, except in the case of brief quotations for use in articles and reviews wherein appropriate attribution of the source is made.
